The Bastardization of U.S. Equity

The Grantham, Mayo, Van Otterloo (GMO) is a private partnership whose sole business is investment management. They recently released a white paper detailing their new model and how it indicates that the U.S. stock market bubble is bursting.

Key Points

A new model suggests that from early 2017 through much of 2018, the U.S. stock market was a bubble.

Driven by negative changes in sentiment, the bubble started to deflate in the fourth quarter of 2018, in spite of strong fundamentals.

Our advice, consistent with our portfolio positions established in Q1 2018 – as usual, we were early – is to own as little U.S. equity as your career risk allows.

Introduction

In the fourth quarter of 2018, the S&P 500 fell almost 14%. This large price drop occurred in spite of a strong fundamental backdrop. Earnings per share (EPS) for 2018, much of it already locked in, is expected to be about $140, a 28% increase over 2017. And expectations for 2019 are for EPS of about $156, a 12% annual increase. With fundamentals so good, what explains the recent price action?

A new model – the Bubble Model – explains this dichotomy between price action and fundamentals by suggesting that a bubble in the U.S. stock market started inflating in early 2017, and continued to inflate through the third quarter of 2018. In the fourth quarter, however, indications were that the bubble had started to deflate.

And when bubbles deflate, they generally do so with a volatility bang. In this new model, bubbles are prone to form when times are good and expected to get even better. Good times today and even better times ahead are reflected in high valuations and solid fundamentals that continue to improve. Improving fundamentals lead to positive changes in sentiment, and these positive changes in sentiment fuel the bubble.

However, sentiment cannot increase forever. When change in sentiment – not level – inevitably turns negative as hopes of even better times ahead are dashed, there is nothing left to fuel the bubble…

While there are indications that the bubble started to deflate in the fourth quarter of 2018, and the magnitude of both price action and the change in the quantitative measure of euphoria that defines the Bubble Model suggests that the odds are now tilted in favor of the view that this is the beginning of the end of the bubble, we would be well-advised to remember Yogi Berra’s counsel that “It ain’t over till it’s over.”

Past bubbles do exhibit “head fakes” in which bubble deflation is interrupted by a secondary growth event. For example, in the third quarter of 1998, the time of the LTCM crisis, the Bubble Model suggested the bursting of the bubble that had started inflating in early 1997. However, the 1998 reading was a head fake, and the bubble continued to grow for another 18 months before finally popping in early 2000.

… The Bubble Model, which focuses on the dynamics of valuation, captures both the quantitative and anecdotal euphoric elements of a bubble. Euphoria manifests as explosive dynamics, expressed quantitatively as a negative mean reversion speed. Because the model is quantitative, it does not suffer from the subjective uncertainties inherent in anecdotal stories. While most of the time valuation is mean reverting, on rare occasions valuation is temporarily explosive, or mean averting. This mean aversion goes hand in hand with expensive valuation and is the defining characteristic of a bubble…

Exhibit 1: Valuation in 2018 Matched the Peak of 1929

Mean aversion, or explosive dynamics, arises when speculators dominate the market. Speculators are subject to fads and fashion and have a tendency to follow the herd. Their demand for stocks is ephemeral. Fundamental investors, on the other hand, assess value based on fundamentals and expected return considerations. Their demand for stocks is relatively stable. To the extent that fundamental investors dominate the market, fundamental value provides an anchor around which market prices vary. This is standard mean reversion.

However, when speculators dominate, i.e., the percentage change in speculative value exceeds that of fundamental value, then price tends to move away from fundamental value because deviations of price from fundamental value get relatively bigger. This is mean aversion.

…

Expansion

In short, what this means is that consumer confidence and sentiment play a huge role in the development of the markets. When there is backdoor manipulation of factors such as interest rates and quantitative easing/tightening by institutions and central banks such as the Federal Reserve, they are able to play a tune that will coax the market and market forces to bend to their will. In turn, this false sentiment can drive the market to change in a way that it would normally not.

Bubbles are prone to form when times are good (when the valuation of equity is high) and are expected to get even better (positive expected change in sentiment). Bubbles burst when hopes of even better times ahead are dashed. When these hopes are dashed, the positive change in sentiment turns negative. According to Tarlie, it is this flipping of the change in sentiment – not the level of sentiment – that drive the system back to a strongly mean-reverting phase. Furthermore, this change in sentiment from positive to negative will undoubtedly occur – as sentiment cannot keep growing forever – which makes the popping of the bubble guaranteed. [1]

How Does This Apply To 2018/2019?

Throughout 2018, the U.S. experienced the highest valuations in market history with the DOW, S&P 500, and NASDAQ reaching unprecedented levels. Yet, in the fourth quarter of 2018, things really started to change. The market fell dramatically despite fundamentals, both past and future, looking solid.

While as of December, 2018 expected EPS growth for 2019 is 12%, this is substantially below the 28% growth of 2018. Furthermore, since August, 2018 estimated EPS for 2019 has been revised downward by more than 4%. These changes, together with concerns about Federal Reserve tightening and trade tensions with China, point to negative changes in sentiment, a catalyst for popping a bubble.

Many claim that if people know a bubble is coming, why aren’t more people getting rich off it? Therein lies the problem. Bubbles are quite easy to recognize. Everyone understands to get in the market before the bubble takes off, ride it to the top, and exit before it pops.

Knowing that all bubbles pop when the overwhelmingly positive sentiment turns negative despite the outlook of increasingly positive sentiment is one thing, but to 1) know when a reversal is in fact a downward spiral and not a head-fake and 2) to be able to identify the correct catalyst for the change rather than the level of sentiment are the real obstacles.

The volatility is consistent with a bubble bursting, though we caution that it is possible that the fourth quarter move in the mean reversion speed could be a head fake. While the dramatic nature of the move in the mean reversion speed to such strong mean reversion suggests that the odds are tilted toward this being the beginning of the end of the bubble of 2017-18, we cannot rule out reflation of the bubble, analogous to the event of late 1998-2000. Given that valuation is still high, our advice, consistent with our portfolio positions, is to continue to own as little U.S. equity as career risk allows.

Protection from Bubbles

GMO recommends minimizing one’s exposure to U.S. equity markets. Their logic being that if the U.S. stock market bubble does pop, one may lose much of their portfolio’s value. Furthermore, if one did not buy in before the bubble took off – back in the QE days – then stay away. It may seem difficult to ignore the clamor of a rising market, but the risks of buying into the market this late in the game far outweigh the possibility of any rewards.

Some wise sage advice is to not just buy low and sell high, but to follow and do as the rich are doing. Many of the rich are exiting the U.S. equity markets and seeking refuge elsewhere for their investments. Either emerging markets with limited exposure to U.S. dollars, real-estate, and a subset of select commodities including gold; yes, gold.

Billionaire Buys Gold For the First Time

For the first time ever, billionaire Sam Zell – the 77 year old founder and chairman of Equity International, a private investment firm focused on building real estate-related business in emerging markets, is buying gold.

For the first time in my life, I bought gold because it is a good hedge.

As has been noted in previous writings, every major financial player is buying gold. Countries from China to Russia, EU central banks and banks such as JP Morgan-Chase are all buying physical – not paper gold certificates – but physical gold.

Zell points out that mining companies are not focused on exploring for new gold. The gold output of existing gold mines is down dramatically compared to the numbers of the past. Instead, many mining companies are taking advantage of the current landscape and buying out their competitors.

For example, Barrick Gold and Randgold Resources combined in an $18.3 billion dollar deal that created the world’s top gold miner by value and output. Meanwhile, just last week, Newmont Mining Corp. announced it was buying Goldcorp, Inc. in a $10 billion dollar deal resulting in a merger that will “create an unmatched portfolio of operations, projects, exploration opportunities, reserves, and people in the gold mining complex.” [3]

So, for Zell, this all goes back to the old law of supply and demand. Not only is gold a real hedge against downturns in the market – as it is real money – it has the likelihood of increasing in value (in relation to fiat currencies) from this drying-up supply.

Go back to supply and demand. Supply is shrinking and that is going to have a positive impact on pricing. The amount of capital being put into new gold mines is almost nonexistent. All of the money is being used to buy up rivals.

Gold Outperforms S&P 500

Despite talk of inflating bubbles and the bull market reaching new highs, the real winner all this time has been gold. Not only is gold a good hedge, but it has outperformed the S&P for over 2 decades. Want the proof? [4][5]

If you look at December, the S&P 500 dropped 9.18%. Gold went in the other direction, gaining 4.93%. And that was even with the headwinds of a Fed rate increase in December that conventional wisdom would signal should have pushed the price of the yellow metal down. (This data was gathered by Forbes. [6])

The fact that gold outperformed the S&P 500 in Q4 may not come as any shock. But it might be surprising to know that gold actually outperformed the stock index over the entire year. The price of gold dropped quite a bit in the spring, but overall, the yellow metal still ended 2018 ahead of the S&P500. Gold ended 2018 down 1.55% on the year while the market was off by 6.24%. [5]

Believe it or not, this trend can be extended out even further. Despite what most people consider a stock market boom over the last couple of years, gold has outperformed the S&P 500 since the turn of the century. Gold is up 345.39% since Dec. 31, 1999, versus a 70.62% increase in the S&P 500. [5]

Here’s the thing. This really shouldn’t come as a surprise. Gold has historically had a strong negative correlation with the stock market and it has long been considered an important hedge in an investment portfolio. As the saying goes, the proof is in the pudding.

As always, one should always do their own research. This is not investment advice though it is common knowledge that one should always allocate at least 10% of their portfolio in gold to hedge against any potential downturns the market may throw one’s way. As long as the U.S. dollar remains a fiat currency, there will be bubbles that are created due to Keynesian economic strategies and gold will always survive to tell the tale. Stay informed.

About Author

Jaise Donovan

Jaise is a conservative-libertarian who believes the sovereignty of the nation lies with "we the people" and not the government. He writes to inform others of the actions of government (or the people in it), to analyze possible outcomes of such actions, and bring to light important issues of the day. He tries to convey his thought process of how it can effect lives on a daily basis both politically and economically – for better or for worse.